The Mysterious World of Bitcoin: Does It Have Staying Power?

Just what exactly should we make of Bitcoin? The once-obscure digital currency has had quite a ride: Fueled by the banking collapse in Cyprus, a wave of speculation and intense media coverage, the value of a single Bitcoin soared from $13 in January to a peak of $237 by mid-April, before collapsing to $83 in a day.

While the crypto-currency has recovered somewhat — it’s now around $134 — the roller-coaster ride left plenty of questions. Is Bitcoin a legitimate alternative currency — an online replacement for dollars and euros, as backers claim? Or are we witnessing a giant bubble — a speculative run-up more akin to the Dutch Tulip frenzy, waiting to burst?

For skeptics like James J. Angel of Georgetown University, a visiting professor of finance at Wharton, the answer is obvious: “Bitcoin has all the hallmarks of a classic speculative bubble,” he says.

The warnings haven’t dissuaded a growing roster of digital currency believers, however — including some prominent Silicon Valley names. On April 11, an investor group including Andreessen Horowitz, the venture capital firm of Netscape founder Marc Andreessen, agreed to finance OpenCoin, a Bitcoin-related firm. And in mid-May, the San Jose Convention Center will host the Bitcoin 2013 conference.

Even the Winklevoss twins of Facebook fame have jumped aboard, telling The New York Times in a recent article that they held Bitcoins then valued at $11 million.

“People say it’s a Ponzi scheme, it’s a bubble,” Cameron Winklevoss told the Times. “People really don’t want to take it seriously. At some point, that narrative will shift to ‘virtual currencies are here to stay.’ We’re in the early days.”

Backers like Winklevoss hail Bitcoin as a new kind of money — in the words of a YouTube promotional video, it’s a “decentralized electronic currency” that will revolutionize global finance the way the web changed publishing or Skype enabled free global phone calls.

Created in 2009 by an anonymous programmer who goes by the pseudonym Satoshi Nakamoto, the currency was designed to facilitate trade, to guarantee the privacy of anyone using it — and perhaps most important — to be out of the hands of any government entity.

“Bitcoin is an open, international payment network,” says Gavin Andreson, the chief scientist of the Bitcoin Foundation, which standardizes and promotes the currency. “It is an easy way to allow anybody, anywhere in the world, to pay for products or services — even people from countries where credit cards and bank accounts might not be common.” It is also very low-cost, he adds, allowing users to escape the often high transaction fees of credit cards, ATMs and other traditional financial services.

‘A Natural Outgrowth of Libertarian Culture’

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In the Bitcoin universe, there is no physical currency. Nor is there a middleman. Bitcoins exist only as electronic records that users transfer to each other through a peer-to-peer computer network. Each new coin is “minted” when a computer attached to the network solves a complex mathematical problem generated by algorithm. Sophisticated cryptography and encryption techniques are said to ensure that only their owner can access Bitcoins.

The supply of Bitcoins is also fixed. From roughly nine million a year ago, some 11 million are in circulation today. As time goes on, its backers claim, growth will slow until they reach a maximum of 21 million Bitcoins in the year 2040.

That fixed money supply is a big draw for many early Bitcoin adherents, notes Angel. It attracts many of the same people who buy gold out of fear that quantitative easing and additional moves by the Federal Reserve and other central bankers will ignite hyperinflation. They see Bitcoins as a safe currency that government can’t destroy by printing up excess paper or “fiat” money. “They trust Satoshi Nakamoto’s algorithm more than they trust Ben Bernanke,” he says.

Others have turned to Bitcoins for privacy reasons, according to Wharton management professor Ethan Mollick. All Bitcoin transactions are anonymous and there are no centralized records of how many Bitcoins anyone has. That, says Mollick, has made Bitcoin attractive to people — including drug dealers, online gamblers and others engaged in illegal activities — who don’t much like government tax collectors or the idea that “Big Brother” can track their transactions.

“It’s a natural outgrowth of libertarian culture,” notes Mollick. “Many people who have invested in it are doing so largely for non-financial reasons.”

Beyond such niche users, Wharton marketing professor Eric T. Bradlow, who is also co-director of the Wharton Customer Analytics Initiative, argues that is it unclear exactly what market need Bitcoin is fulfilling or what problem it is solving. The current electronic payments system works effectively for the most part; making payments, getting cash or transferring money is relatively easy, Bradlow points out. While many merchants complain about high fees, as a practical matter few would have reason to use Bitcoin unless it became far more widespread.

“At the moment, why do people need Bitcoins?” Bradlow asks. “The ‘product’ has no obvious customer segment, point of differentiation and obvious consumer need that it is satisfying in comparison to other competing products. Therefore, it will struggle to be highly adopted.”

‘Cyprus Was the Spark’

Moreover, the very properties that its proponents value make Bitcoins far from an ideal currency. Effective currencies have a number of key properties, says Steve H. Hanke, a professor of applied economics at Johns Hopkins University. Among the most important qualities: the ability of a currency to provide a stable store of value and to serve as a medium of exchange.

Bitcoins don’t measure up on either of those counts, Hanke and others note.

For starters, the digital currency has been extremely volatile, precisely because of its limited supply. That raises obvious doubts about its effectiveness as a safe place to store money, as investors saw in April. The extreme spike came as the Cypriot government moved to impose capital controls. Its attempt to resolve the crisis by making bank depositors take a haircut also woke up savers across the globe to the risk that funds could be confiscated in a bank failure.

“Cyprus was the spark,” says Hanke. “The idea that depositors could escape national capital controls through the use of a virtual currency created a worldwide buzz.”

Critically, however, Bitcoin purchases didn’t take off in countries teetering on the ledge of a currency crisis, experts note. The vast majority of the purchases took place in the U.S. In other words, U.S. buyers placed big bets that Cypriots and others would seek protection in Bitcoins, so they bought them ahead of that expected demand. With a limited supply in circulation, prices took off — much as they did in the dot-com run up of the 1990s, the housing boom a few years later or with Dutch Tulips four centuries before.

“Every bubble starts with a plausible story, something that’s valuable and will likely be more valuable in the future. People buy it, the price goes up, and it feeds on itself — until it doesn’t anymore,” says Angel.

That price volatility also makes Bitcoins a lousy medium of exchange, notes Mollick. Without price stability, it’s hard to know what you’re paying for something. If you bought a house and agreed to pay for it with Bitcoins in mid-April, you might have ended up paying 50% more or less than the day before in dollar value, depending on what day you signed your contract.

Is It Even Legal?

The extreme privacy that attracts many users to the Bitcoin is another potential source of problems. For one, there’s the risk that the network’s tight security could be cracked. In an unregulated, government-free zone, who will police against reputed robberies or frauds? “Any cyber currency will be a target for hackers,” warns Bradlow. It’s hard to imagine authorities stepping in to help victims who have chosen to operate in a network set up explicitly to evade government control.

Theft isn’t the only vulnerability. To mine new Bitcoins, users link their computers into a global peer-to-peer network. Angel points out that there’s no way to know what else might be running on that network. “It could be downloading malware, or preparing the next big distributed denial of service or spam attack,” he says.

Bitcoin is also swimming in uncharted waters when it comes to its legal and regulatory situation, says Wharton legal studies and business ethics professor Andrea Matwyshyn. The most obvious question is whether Bitcoins are even legal. In the U.S., as in most countries, only the federal government can issue legally recognized tender. “Whether these types of alternative currencies can co-exist with traditional models is an unanswered question,” says Matwyshyn. “It’s such a new regulatory space that the law isn’t there yet.”

So far, Bitcoin hasn’t triggered much attention on the part of the U.S. or other governments, given the tiny size and newness of the market. But the rise in valuations and growing involvement of venture capital firms could bring more scrutiny. “It triggers some of the same concerns we saw around securities when they first began to be regulated,” Matwyshyn notes.

Hanke of Johns Hopkins goes further. Since governments make enormous profits from their monopoly on printing money, he suggests that they won’t allow Bitcoin to emerge as a viable rival. If the digital currency expands beyond its niche, Hanke has little doubt the government will move to closely monitor it to prevent tax or securities fraud and avoid the risk of destabilizing the financial system. “If this becomes a commercial threat to the state production of money,” says Hanke, “there will be a million reasons trotted out to restrict it or prohibit it.”

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